Part II: Best Practices for Manager Selection

Once an investment strategy has been selected, it’s good practice to document the buy rationale. Manager theses typically contain a brief outline of the selection rationale and also provide details about:

• Asset management firm
• Investment team
• Investment strategy (inception date, assets under management, capacity, expenses, etc.)
• Investment philosophy and process
• Portfolio construction (number of holdings, risk controls, concentration, etc.)
• Performance drivers

This level of detail may be more than some financial professionals need, unless a particular element played a significant role in the selection decision.

It’s also prudent to record areas of weakness or concern, as well as any reevaluation triggers. In other words, make a note of key issues that could prompt a review or termination of the strategy, such as a portfolio manager change, style drift, assets under management exceeding a preset capacity, and others.

(Fig. 1) Equity Income Strategy Sample Performance Expectations

The second half of a structured manager research process is ongoing monitoring. Overall, the goal is to ensure that buy-list strategies continue to exhibit the desired characteristics. It’s also important to look for performance patterns inconsistent with the strategy’s investment process. For professional gatekeepers, this is a multistep process including:

• Participating in periodic meetings with the investment team and subscribing to regular product updates
• Systematic monitoring of quantitative data points
• Third-party information, such as industry news sources

A systematic monitoring process should include key measurable data most appropriate for each asset class and investment type. For example, characteristics such as duration and credit quality are specific to fixed income strategies. Additionally, the target ranges may be different even when using the same statistics. When monitoring passive strategies, for instance, very low tracking error to the benchmark is typically desirable, whereas higher tracking error is generally expected for actively managed strategies.

The frequency of monitoring is another consideration. When using an automated screen to monitor performance, risk metrics, or other quantitative factors, a quarterly or semiannual cadence may be useful. If in-house screening resources aren’t available, third-party services, such as T. Rowe Price’s Art of Clean Up®, may be able to help with this task. It’s generally a good practice to get an update from the asset manager at least annually. However, professional gatekeepers often have a different schedule based on the type of strategy or level of client assets invested. Passively managed strategies, for example, may require less frequent interactions with managers, while greater engagement may be warranted for active strategies and/or those with significant position sizes.

Based on the time and resources required for a specific monitoring process, it’s important to consider how many strategies can be monitored effectively. This may help to inform the number of line items on a buy list.

(Fig. 2) Manager Selection and Active Performance

Knowing when to exit an investment is among the most difficult decisions made by financial professionals. Typically, it’s prudent to be patient and allow an investment time to work, but there is also merit to recognizing mistakes early. The key is identifying changes or issues that invalidate the investment thesis. Although there may be criteria that, if breached, instantly result in termination, we strongly believe that underperformance by itself is not a valid reason to exit an investment. Adherence to a disciplined investment process makes it very difficult for strategies to outperform in every market condition. It’s unexpected underperformance that deserves attention.

As shown in Figure 2, research conducted by the CFA Institute suggests that terminating underperforming strategies and replacing them with managers that are currently outperforming ultimately leads to underperformance when compared with following a more disciplined hire/fire process. Essentially, the same “buy high, sell low” behavior that traps many investors. Defining performance pattern expectations at the time a strategy is added can help identify performance anomalies during regular monitoring activities.

While manager selection and monitoring may seem overwhelming, creating and documenting a structured process can increase confidence in your selections, help to address regulatory considerations, enhance investment outcomes, and allow you to focus on building and managing your practice.

Although it doesn’t relieve financial professionals from their due diligence responsibilities, third-party portfolio construction services can help. Portfolio Construction Solutions from T. Rowe Price, for example, can help assess models and managers and help keep you up to date on industry perspectives and trends.

Our dedicated team of professionals work with financial professionals to find practical solutions for critical investment and practice challenges. Used independently or in combination, our integrated suite of Portfolio Construction Solutions provides access to T. Rowe Price’s world-class multi-asset expertise and global investment resources to address your portfolio construction needs.